(Bloomberg) — Bank of America Corp. sees the $3 trillion U.S. corporate pension industry throwing its interest-rate assumptions out the window.
And that means the retirement plans will probably throw more money into Treasuries.
Even with yields at record lows, Shyam Rajan, head of U.S. rates strategy at the primary dealer, says pensions are likely to embrace the lower-for-longer mantra and bolster the $13.4 trillion Treasuries market. With only 6% of assets in Treasuries, half the peak seen in the 1980s, the retirement funds are primed to join buyers looking for a selloff to pounce. That demand waiting in the wings may depress yields further. Bank of America forecasts yields on 10-year notes will fall to 1.25% by the end of September, from about 1.39% as of 12:10 p.m. in New York on July 6.
“As a pension fund, you’ve got to be scared that rates could actually go lower,” Rajan, who’s based in New York, said in an interview. “There’s a perceived permanence to this rate rally. If you were assuming that rates were going to go back to 3%, that’s not going to happen anytime soon.”
Consensus forecasts for higher Treasury yields have proven wrong as economic growth remains tepid and inflation is short of the Fed’s target even after unprecedented monetary stimulus. Instead of witnessing the end of the bull market for U.S. debt that began in the early 1980s, investors have seen yields drop amid worldwide demand for haven assets.
Benchmark yields fell to record lows this week, with 10-year notes dipping below 1.32%. They peaked above 15% three decades ago.
For defined-benefit pensions, the pain of depressed yields is acute because the phenomenon alters the discount rate used for their liabilities. The lower the rate, the larger the obligations look, and the more money they need to contribute to fill the gap.
The 100 largest U.S. plans face a combined $401 billion deficit, and have 77.5% of assets needed to meet future obligations, according to Milliman Inc. data through May. That compares with a $285 billion shortfall and an 83.7% funded ratio 12 months earlier.
The decline shows that the move lower in global interest rates is outweighing gains in the S&P 500 Index over the past five years, Rajan said.
Moreover, the bond market is signaling little risk. In the U.S., a metric known as the term premium is an unprecedented minus 0.61 percentage point for 10-year notes. The measure, which the Federal Reserve uses in guiding policy, reflects the extra compensation investors demand to hold longer-maturity debt instead of successive short-term securities.
The gauge has been positive for almost all of the past 50 years. But since the start of the year, it’s turned into a discount, suggesting investors don’t see any threat on the horizon that would push yields higher.
“There’s been a conscious attempt to move more into the fixed-income space for some of the largest 100 plans, in an attempt mainly to de-risk their liabilities,” said Zorast Wadia, a principal at Milliman in New York. “The feeling is ‘How much lower can rates go?’ But every time people have said they’re already at their bottom, they’ve been wrong.”
One concern for companies, Rajan says, is the potential for penalties for underfunding. The top 100 -- a group that includes IBM and General Motors Co. -- may wind up paying $20 billion a year combined by 2019 unless they shore up their funds, according to his calculations.
“In the simplest de-risking scenario, pension managers would stop underestimating the perceived lower bound for U.S. rates and be more aggressive in using rate sell-offs to close duration gaps,” Rajan said in a report dated July 1.
In other words: Welcome to the lower-for-longer club, pension funds.
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